Compound interest

Long-term investing and the power of compound interest

Compound interest can potentially generate returns on investment over a long period of time, but there are a few things to consider, such as time, reinvestment, and the importance of managing risk.

Key points to remember

  • When it comes to capitalizing, it is important to consider the effects of time, reinvestment and risk
  • Over time, different assets grow at different rates, so consider reviewing and rebalancing your portfolio periodically.

Portfolio management is the ongoing maintenance of your long-term investment portfolio. This means reviewing your asset allocations, adding new money, reinvesting interest and dividends, managing risk by rebalancing, and maintaining a long-term perspective.

First of all. A long-term investor can potentially harness the power of compound returns (commonly referred to as compound interest in the case of bonds, certificates of deposit (CDs) and other fixed income investments). Compound interest is basically interest earned in addition to interest. When it comes to composition, there are three things to consider:

  1. The sooner money is used, the sooner it can start to accumulate.
  2. Reinvestment can contribute to compound growth.
  3. Excessive risk can contribute to large losses, which can erode the long-term effects of funding.

Compound interest has been called the eighth wonder of the world. And when you look at a graph like Figure 1, the effects can be impressive. But really, it’s just simple math. But as we’ll see in the next section, it can be a bit too straightforward, as it ignores setbacks, like corrections, bear markets, and recessions, that can arise along the way.

FIGURE 1: THE POWER TO COMPOSITION. An investment of $ 24,000 at a stable compound interest rate results in a significantly higher total when it started 26 years earlier. For illustrative purposes only. Past performance is no guarantee of future results.

The basics of composition

Suppose you have $ 1,000 earning 5% per year. It’s $ 50 a year, right? Yes, but then it starts to get worse. After this first year at 5% interest, you now have $ 1,050. Add the same 5% interest and you get $ 52.50 the second year for a total of $ 1,102.50. In the third year, your total increases to $ 1,157.63 ($ 1,102.50 x 1.05). Yes, the additional earnings beyond the original $ 50 interest are small at first, but they get bigger over time.

This is why it is important to reinvest any compound return. If, instead of reinvesting that $ 50, you took it out and spent it on a nice dinner out, you’d only earn an extra $ 50 in year two instead of the $ 52.50 compounded. There’s nothing wrong with splurging on the occasional basis, but when it comes to investing for the future, you can’t have your makeup and eat it too.

Managing risk: an act of rebalancing

Now that we’ve looked at the importance of time and reinvestment, let’s turn our attention to risk. Over time, assets such as stocks or bonds grow at different rates. Bonds are designed to offer a fixed rate of return and are generally considered to be less risky. Over longer periods of time, the stock market has historically generated higher returns, but as the standard disclaimer says, past performance is no guarantee of future results. The stock market can be volatile, and volatility can expose you to disproportionate losses on certain assets.

Suppose you’ve assessed your goals and tolerance for risk and gone for a 50/50 mix of stocks and bonds. FFigure 2 shows how a portfolio can become “imbalanced” over time if left alone. That’s why it’s important to consider rebalancing your portfolio periodically in order to maintain your target asset allocation.

Importance of rebalancing investment portfolios

FIGURE 2: THE IMPORTANCE OF REBALANCING. Over a 20-year period, a hypothetical 50/50 allocation gradually becomes 69% equities and 31% bonds. Data Sources: Small stocks are represented by the Ibbotson Small Company Stock Index. Large stocks are represented by the Ibbotson Large Company Stock Index. Medium-term government bonds are represented by the five-year US government bond. An investment cannot be made directly in an index. Data assumes reinvestment of income and excludes taxes or transaction costs. Image source: Morningstar. For illustrative purposes only. Past performance is no guarantee of future results.

Note how the composition of the allowance changes over each five-year period. The 50/50 mixture becomes 60/40, then 63/37. This imbalance creates a higher risk in the portfolio, which results in larger fluctuations in its value by 2005. Subsequent market fluctuations cause the allocation of shares to decrease to 60% in 2010 and increase again to 69% in 2015.

Note two key points here. The actual portfolio allocation at the end of the period is radically different from the initial 50/50 target allocation. And as the equity allocation increased, so did the risk of the overall portfolio.

Regular review

How can an investor help control this risk and maintain a long-term perspective? Consider performing a portfolio review quarterly to determine if you need to rebalance your assets. Rebalancing simply means selling part of an asset that has become overweighted. These funds are then added to an underweight asset, restoring your target allocations.

You can also manage risk and restore your target asset allocations by adding money to a portfolio. For example, if you started with an allocation of 50% stocks and 50% bonds, and it increased to 60% stocks and 40% bonds, you could direct the new money to the obligations. Over time, the bond allocation should grow and come back into alignment with your target 50/50 allocation.

Ultimately, portfolio management comes down to managing risk and being patient. Remember, when it comes to your investments, compound interest and compound returns can be important allies. Putting your money to work as early as possible gives it more time to grow and to recover from any slowdowns along the way. For more information on the power of composition, watch the video below.

Fundamentals of investing: the power of capitalization

Investools, Inc. and TD Ameritrade, Inc., are separate but affiliated companies which are not responsible for the services or policies of the other. Ryan Campbell is not a representative of TD Ameritrade, Inc.